There are many differences between Austrian economics and the neoclassical mainstream, but one of the most critical involves the difficult field of “capital & interest theory.” (Here are three links of increasing difficulty to show the Austrian perspective on these issues: one, two, and three.) This area has been dubbed the “black hole of economics” because it can devour researchers, but in the present post I can use a recent Paul Krugman blog entry to graphically illustrate the Austrian viewpoint. Specifically, Krugman’s diagram doesn’t even get the dimensions right!
Before diving in, I should acknowledge that this particular dispute has nothing to do with Keynesian policy recommendations. Rather, the problem in Krugman’s diagram is something that is taught in standard economics programs, whether Keynesian, Public Choice, or Chicago School.
In a debate over the impact of a cut in the corporate income tax rate, Krugman produced the following chart and commentary:
[W]e can represent the economy with Figure 1, which has the stock of capital on the horizontal axis and the rate of return on capital on the vertical axis. The curve MPK is the marginal product of capital, diminishing in the quantity of capital because of the fixed labor force. The area under MPK – the integral of the marginal products of successive units of capital – is the economy’s real GDP, its total output. [Krugman, bold added.]
My point here is very simple: Look at the y-axis on Krugman’s Figure 1. As he says in his text, it refers to “the rate of return on capital.” In other words, the units of the y-axis are percentages.
Just to make sure you believe me, notice that the expression r*/(1-t) is showing the world rate of return on capital, adjusted by the tax rate on capital imposed by the U.S. federal government. Since tax rates are in percentages, clearly the units of the y-axis itself must be pure percentages.
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